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FEATURE / SURETY BONDS IBAMAG.COM December 2015 SURETY BONDS: BOOMING BUT MISUNDERSTOOD Ages-old surety pervades modern society, but the average person’s understanding of it is still stuck in the dark ages. Surety has been around since the dawn of human commerce, back when contracts were literally written in stone. Historians have sleuthed out evidence of individual surety bonds in the legendary Code of Hammurabi. (A well-preserved Babylonian law code, chiseled into a 2.3-meter-high stone column dating to about 1754 BC.) They’ve also found evidence of surety bonds in Persia, Assyria, Rome and Carthage; among the ancient Hebrews; and (much later) in England. Surety is just as pervasive in our world today. It finds its expression through a vast array of surety bonds – legally binding mechanisms that financially guarantee the performance of an individual or a business. Surety bonds represent $5 billion worth of premium annually. The average person’s understanding of surety, however – and how it fits into the wider world of insurance – seems stuck in the dark ages. Perhaps that’s because surety bonds are unique – part insurance, part financial product – with an intense underwriting process that sets them apart from the rest of the insurance industry. “Surety represents a small portion of the overall insurance world that not many people know about, and we’re okay with that,” says Bill Krumm, who heads up Arthur J. Gallagher & Co.’s national commercial surety practice. But as more public entities and private companies require guarantees that products will be delivered and services will be performed, “Being bonded can mean the difference between being invited to bid on a contract and readying about the award in the newspaper,” Krumm says. How bonding works A surety bond is essentially a third-party guarantee. A three-way agreement between a principal– a person or entity required to post bond; an obligee – a government entity or person requiring principal to be bonded; and a surety– provides financial guarantee to obligee on behalf of principal person of the surety company. Surety bonds come in two major categories: contract and commercial. Most premium in the surety market is in the contract surety area – “sticks & bricks” and heavy-construction projects such as highways, bridges, dams, dredging, public infrastructure, schools, local parks and recreation. The federal government (under the Miller Act) and most states mandate that publicly funded projects over a threshold dollar value – which varies from state to state – must include some form of “guarantee” protecting the public’s interest. “This guarantee, usually a contract bond, assures that the selected contractor and its team of subcontractors and suppliers will complete the project as specified – on time, on budget and without lien,” explains Krumm. “Surety isn’t just for publicly funded projects. We’re seeing sophisticated private owners require bonds to protect their construction projects.” Some of the most common forms of contract bonds are: •Bid bonds, requiring contractors to enter into the contract if their bid for a project is chosen and allowing the project developer to recover the difference between that bid and the next-lowest bid if a contractor refuses to accept the contract. •Performance bonds, providing project owners and developers with financial protection in the event that a contractor doesn’t finish the project according to contract. •Payment bonds, ensuring that contrac- tors will pay subcontractors, suppliers and laborers as outlined in the contract. Other miscellaneous bonds commonly written to support the construction industry include wage and welfare bonds, license and permit bonds, highway and roadway access bonds, and various preservation bonds. Commercial surety bonds, meanwhile, are generally required by state laws and statutes rather than by contract, and guarantee some aspect of a principal’s occupation. “They’re used to regulate markets and keep working professionals from taking $ $ $ $ $ $ THE WHOS OF SURET Y BONDS WHO NEEDS THEM? $ $ $ $ $ $ A few professionals that almost always require surety bonds: Auto dealers Real estate brokers $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Construction companies $ $ $ $ $ $ $ $ $ $ $ $ Collection agencies $ $ Durable medical $ $ $ $ equipment providers Health clubs Auctioneers Travel agencies These three parties in a surety guarantee: Principal – person or entity required to post bond Obligee – government entity or person requiring principal to be bonded Surety – provides financial guarantee to obligee on behalf of principal part in fraud and other unethical business practices,” explains Danielle Rodabaugh, director of education at SuretyBonds.com. “Most commercial bonds are license and permit bonds – which are required before government agencies issue a license or permit. Their purpose is usually to safeguard the public and keep the government from losing money.” There are thousands of different types of commercial bonds that surety companies offer. Among the most frequently purchased are contractor’s license bonds, tax preparer bonds, notary bonds, and judicial and fiduciary bonds such as probate bonds. The difference between surety and insurance When a business obtains a surety bond, it pays a fraction of the whole sum of a surety bond to the surety bond company. Payment ranges from 1% to 3% of the bond amount for well-qualified applicants, all the way up to 25% for applicants with less-than-stellar credit or limited financial history. If the principal fails to fulfill the bond’s obligations, the harmed party can make an indemnity claim. If the claim is valid, the surety will provide compensation up to the bond amount. A bank line of credit is generally secured with equipment or other assets such as real estate. Surety, however, is typically supported in an indemnity agreement stating the bonded company will reimburse the surety for any and all losses and costs. Underwriting surety bonds Bonded principals must therefore take every action possible to avoid claims. “The surety is only extending you credit, and therefore will expect to be reimbursed if a valid claim is paid,” stressed Victor J. Lance, president of Lance Surety Bond Associates. “Having a paid surety claim may make it very difficult for the principal to become bonded again in the future, as it is a standard question on all bond applications, and is usually a cause for declination.” $ Just as surety is more like banking than insurance, surety underwriting is more financially driven than other insurance classes. “It’s underwritten very similarly to what a bank would go through to extend a line of credit,” Krumm says. For smaller clients such as a family held construction company, surety writers take a very hands-on underwriting approach underscored by a through vetting of the “Three C’s of Surety”: character, capital and capacity. Publicly traded Fortune 1000 companies seeking surety bonds require quite a different underwriting approach. “While the financial strength of the company may not be at issue, a key difference may be understanding various uses of surety,” Krumm says. “A great example would be using a surety bond in lieu of a letter of credit – something more readily supported by surety in recent years.” “With the market moving out of a recession and beginning to grow more steadily, the right carrier can help producers provide effective surety solutions for their clients,” Thomas says. Reclamation bonds are among the most difficult to place. They guarantee restoration of land to its original condition after an extractive industry – such as mining, oil or natural-gas development – scars the landscape. They’re required by the Bureau of Land Management and various state environmental agencies. Market update These bonds represent long-term surety obligations that generally cannot be canceled; adequate performance can be highly subjective and bond losses, if incurred, can be large. Surety experts agree business is trending upward in their sector. Specifically, as the real estate sector continues to recover, “We have seen a robust uptick from regional and national FA S T FAC T S $5 billion $ Annual premium in the surety bond market Major Surety Carriers • The Hanover • ACE Group • American Contractors Insurance Group •Chubb •CNA $ $ $ $ $1.2 billion $ $ $ $ $ 2013 surety underwriting profit $ $ $ $ $ $ $ $ $ $ $ • HCC insurance Holdings • International Fidelity Insurance Company • Liberty Mutual • The Hartford •Travelers THE BASIC FOURS Contract surety bonds: • Bid bond • Performance bond • Payment bond • Maintenance bond Commercial surety bonds: • License and permit bonds • Court bonds • Fiduciary or probate bonds • Public official bonds homebuilders for new subdivision bonds,” said Robert F. Thomas, president of Hanover Surety. Thomas predicts upcoming regulatory changes for bonds required in the oil and gas sectors will also result in a higher demand for surety in challenged sectors that are struggling with low fuel prices. The recent growth of the bonding industry means there’s now a significant premium base. It’s about $5 billion annually in the US, and also growing in overseas markets. On the flip side, there’s also increased competition for that premium. There are new entrants into the marketplace, capacity is plentiful and inevitably, price wars have started. Meanwhile, the ample capacity means surety brokers typically will be able to find a home for most opportunities. Great opportunities Thomas sees tremendous opportunity for producers to sell value by establishing surety lines of credit for their clients. “For qualified businesses, a surety line of credit through an independent agent often is a much better alternative than working with a bank,” he says. Great opportunities exist for producers when it comes to partnering with the right surety insurance carriers. “With the market moving out of a recession and beginning to grow more steadily, the right carrier can help producers provide effective surety solutions for their clients,” Thomas says.